The Nation's Balance Sheet and Crowding Out

Recently, I pointed out (in "Kissing
Assets Goodbye" from November 1st) that disasters lower a country's
net worth. Therefore, even though they will tend to increase flows-based
measures of economic activity, such as today's New York ISM where the "6-month
outlook" subindex jumped from 57.7 to 75.3, it's not good news. I
lamented that, although the numbers are not wrong per se, they are
misleading. And they are misleading because there is no economic "asset" and "liability" account
for the nation.

I recently saw a paper which attempts to create just such a "balance sheet" for
the nation, albeit with a very long lag. It is a project to define "the integrated
macroeconomic accounts" of the United States, and it is jointly produced by
the Bureau of Economic Analysis and the Fed. You
can find a discussion of the effort here, and if you search on "disaster
losses" you can find evidence on household, government, and business balance
sheets of the impact of Hurricane Ivan in 2004 (about $28bln) and Hurricanes
Katrina and Rita in 2005 (about $110bln).

Read through the paper and you can see this is an ongoing project with many
current shortcomings, but it's progress. However, it's doubtful it will ever
be used by economists in anything approximating real time, which means my
objection - that economists ignore the fact that a disaster is a net negative
even though it is positive in an activity sense - stands. Still, with as much
as I bash economists, it's only fair that sometimes I point out when they're
trying to do things the right way.

Now, one interesting part of the paper is on page 6, where the economists
detail the sources of net lending and borrowing in the capital and financial
accounts, broken down by sector. For those who think that deficits don't matter,
this is something to chew on. According to the table, in 2007 we were all
borrowing: households, businesses, state and local governments, and the federal
government. This was financed by our overseas trading partners. Everything
changed in 2008, when the government borrowing "crowded out" private borrowing.
The table below is a summary of two columns from the paper, and compares net
lending or borrowing by sector for 2007 and 2011.

(billions)

2007

2011

Households & nonprofits

-126

476

Nonfinancial noncorporate businesses

-74

-6

Nonfinancial corporate businesses

-94

422

Financial business

-3

125

Federal government

-315

-1357

State & local governments

-93

-113

Rest of the world provides the difference

716

484

- indicates net borrowing
+ indicates net lending

The last number in the column is essentially the number needed to make the
column sum to zero (although not exactly, due to statistical discrepancies...that
is, it isn't a "plug" number but rather is measured directly), and it clearly
is bounded at some level. The rest of the world will not lend us, especially
in the current economy, a bazillion dollars. And when so many other countries
are running large deficits, there is great competition for those dollars.
So the "rest of the world" line cannot simply rise to any level in order
to balance out the column. (When our economy was less open, this line was
far less flexible even than it is today).

Consequently, when the "Federal government" deficit rises by a trillion dollars,
it essentially forces (in a mathematical and accounting sense that the books
must balance) the other sectors to become lenders. Or, put another way, if
no one buys the bonds then the federal government can't run that deficit;
ergo, the existence of the deficit implies that other sectors have lent.

A more-generous interpretation would be that the other sectors became savers
due to the crisis and so, in order to maintain economic growth, the Federal
government was forced to borrow. Aside from being a false choice (the government
could have chosen to let the economy solve its own problems), that interpretation
is less plausible now that we are four years out from the crisis and the deficits
still persist.

There are other ways to illustrate this same proposition, such as through
the numbers the Fed produces in the Z.1 report, which show that Treasury debt
has gone from being 25% of total domestic non-financial sector debt to 40%,
in only four years (see chart below, source Federal Reserve Z.1 report).

However, this doesn't illustrate the "crowding out" causality as well as the
table above does. The following chart (Source: Fed Z.1 report) shows it better,
but it still begs the question a bit because it shows levels and not flows.
For my money, I like that table.

All in all, the paper is worth reading - it's only 17 pages, and lots of great
charts and numbers to go with that.

Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.